A letter of credit (LC) is a financial document issued by a buyer’s bank (called the issuing bank) with the purpose of guaranteeing their customer’s (your buyer) payment to a U.S. exporter (domestic supplier or seller). The U.S. bank (called the advising or confirming bank) will received payment, on time and for the correct amount, once the goods arrive and the issuing bank receives documentation that this has occurred; there is no quality assurance that the products are in good condition–it is simply a financial instrument to ensure payment given all the terms specified in the contract are fulfilled. Many LCs have discrepancies so it is very important to abide by the language and terms set forth in the LC. .In the event that your foreign buyer (the importer) is unable to make payment on the purchase, the issuing bank will be required to cover the full or remaining amount of the purchase. If you have a confirmed LC, the seller’s bank (advising bank) will be required to cover the full or remaining amount of the purchase should the issuing bank fail to do so.
LCs are one of the most secure instruments available to international traders. An LC is a commitment by a bank on behalf of the buyer that payment will be made to the exporter, provided that the terms and conditions stated in the LC have been met, as verified through the presentation of all required documents. The buyer establishes credit and pays his or her bank to render this service. An LC is useful when reliable credit information about a foreign buyer is difficult to obtain, but the exporter is satisfied with the creditworthiness of the buyer’s foreign bank. An LC also protects the buyer since no payment obligation arises until the goods have been shipped as promised.
The Letter of Credit Process
There are different types of L/Cs; the definitions below come from Investopedia.
- Standby–A guarantee of payment issued by a bank on behalf of a client that is used as “payment of last resort” should the client fail to fulfill a contractual commitment with a third party. Standby letters of credit are created as a sign of good faith in business transactions, and are proof of a buyer’s credit quality and repayment abilities. The bank issuing the SLOC will perform brief underwriting duties to ensure the credit quality of the party seeking the letter of credit, then send notification to the bank of the party requesting the letter of credit (typically a seller or creditor). Also known as a “non-performing letter of credit”. A standby letter of credit will typically be in force for about one year, allowing for enough time for payment to be made through standard contractual guidelines. Standby letters of credit are often used in international trade transactions, such as the purchase of goods from another country. The seller will ask for a standby letter of credit, which can be cashed on demand if the buyer fails to make payment by the date specified in the contract. The cost to obtain a standby letter of credit is typically 1-8% of the face amount annually, but the letter can be canceled as soon as the terms of the contract have been met by the purchaser or borrower.
- Confirmed--A second guarantee, in addition to a letter of credit, that commits to payment of the letter of credit. A confirmed letter of credit is typically used when the issuing bank of the letter of credit may have questionable creditworthiness and the seller seeks to get a second guarantee to assure payment. A letter of credit is a document issued by a bank that allows the holder of the letter to draw the funds as stated on the letter from the issuing bank. In contrast to a confirmed letter of credit, if the seller does not seek the second guarantee, the document would be called a unconfirmed letter of credit.
- Transferable–A letter of credit that permits the beneficiary of the letter to make some or all of the credit available to another party, thereby creating a secondary beneficiary. The party that initially accepts the transferable letter of credit from the bank is referred to as the first beneficiary. The bank issuing the letter of credit must approve the transfer. The transfer of credit must be clearly outlined in the documentation of the letter. However, the letter of credit must state expressly that the credit is transferable. Otherwise, no credit can be transferred regardless of any other factors.
- Assignment of Proceeds–A document transferring all or part of the proceeds from a letter of credit to a third party beneficiary. To receive an assignment of proceeds, the beneficiary of a letter of credit is required to submit, in writing, a request to the bank to assign the funds to a different person or company. Once approved, the bank will disperse the funds accordingly, pending the fulfillment of any requirements set forth in the letter of credit. However, if the principal party does not meet the obligations outlined in the letter of credit, no assignment will take place.
- Back to Back–Two letters of credit (LCs) used together to help a seller finance the purchase of equipment or services from a subcontractor. With the original LC from the buyer’s bank in place, the seller goes to his own bank and has a second LC issued, with the subcontractor as beneficiary. The subcontractor is thus ensured of payment upon fulfilling the terms of the contract. Like most LCs, back-to-back LCs are used primarily in international transactions, with the first LC serving as collateral for the second.
The Trade Finance Guide, Chapter Three: Letters of Credit
Sample Irrevocable Letter of Credit from Unzco